Is Debt-to-GDP a Good Measure?

Hello, I appreciate your article, however, I still wondering what is the meaning of the National Debt over GDP ratio? My numbers based on the US debt clock http://www.usdebtclock.org/index.htmlshow me that this ratio currently around 98%. Could you briefly explain what is the meaning behind this number?

Others might find the answer useful, so I’m making a post out of my response.

The “national debt” is the total money borrowed by the national government. It is the sum total of all the bonds and T-bills that have been issued and still outstanding by the U.S. government regardless of who owns (the lender or creditor) the bonds. In some cases, one unit of the government such as Social Security owns the bonds which means in effect that one part of the government owes money to another part of the government. In other cases, the central bank, The Federal Reserve, owns the bonds. For details on the breakdown on the U.S. debt see here.

For centuries, nations have borrowed money and for centuries, there have been national governments that have found themselves unable to pay back the money or at times to even pay the interest on the money they borrowed. These events are called “sovereign defaults”. Economists are interested then in the is How much debt is too much? Can the government bear the interest costs of the debt? It is much the same kind of question that a bank asks about an individual when making a loan to an individual. But there are important differences.

In doing this we are trying to compare the amount of debt to some measure of the government’s ability to make the payments. The debt-to-GDP measure is simply a percentage number using total debt outstanding as the numerator and the size of GDP as the denominator. We use GDP as a measure of the government’s ability to pay since a government’s income is taxes. The taxes that can be collected depend on the total of all economic activity. After all, you can’t collect taxes of $1 trillion from an economy of only $500 billion, but it’s easily plausible to collect $1 trillion in taxes from an economy of $15 trillion. The higher GDP is, the more it is assumed the government has an ability to collect taxes and pay the interest. Thus when the ratio is higher, it indicates that a lot of debt is outstanding and that implies (but only implies, not requires) a lot in interest payments. So, it is assumed by many that a higher debt-to-GDP ratio means interest payments are likely a greater burden and thus the chance of eventual default higher.

Using a debt-to-GDP ratio carries two major advantages over just using amounts of debt. First, it allows us to compare two different countries regardless of their size. For example, we can compare a small, little country like Greece which has a debt-to-GDP ratio that’s around 153% to a very large economy like say Germany which is around 84%. Even though Greece has much, much less actual debt outstanding, it’s debt is a bigger burden on it than Germany’s debt is for Germany because Germany has a bigger economy and more ability to pay. Second, using the ratio allows us to compare debt levels of a country from different years. Debt may be growing in dollar terms but becoming less of a burden because the country’s GDP is growing faster. This was the experience of the U.S. since World War II. In WWII debt-to-GDP reached 112%. Ever since then, the U.S. has had an increasing debt because it almost always ran a budget deficit. But the debt-to-GDP ratio declined from 1948-1981 because the economy grew so fast.

Why There’s So Much Attention to the Ratio In Recent Years

A paper written last year by Carmen Reinhart and Kenneth Rogoff, called “Growth in a Time of Debt,” has been widely quoted for its analysis of 44 countries over 200 years, which found that when government debt exceeds 90 percent of GDP, countries suffer slower growth, losing about one percentage point on the annual rate.

One might be misled into thinking that, because 90 percent sounds awfully close to 100 percent, awful things start happening to countries that get into such a mess. But if one reads their paper carefully, it is clear that Reinhart and Rogoff picked the 90 percent figure almost arbitrarily. They chose, without explanation, to divide debt-to-GDP ratios into the following categories: under 30 percent, 30 to 60 percent, 60 to 90 percent, and over 90 percent.

And it turns out that growth rates decline in all of these categories as the debt-to-GDP ratio increases, only somewhat more in the last category.

There is also the issue of reverse causality. Debt-to-GDP ratios tend to increase for countries that are in economic trouble. If this is part of the reason that higher debt-to-GDP ratios correspond to lower economic growth, there is less reason to think that countries should avoid a higher ratio, as Keynesian theory implies that fiscal austerity would undermine, rather than boost, economic performance.

The Problems With the Ratio

One major problem with the ratio is that people misunderstand it, as Shiller explains. Many people think that a ratio of over 100% means the country is insolvent or bankrupt. That’s false and a fallacy. Many mainstream economists claim to be uncomfortable with ratios of over 90%, but that’s purely an arbitrary pick that reflects ideology more than economic experience. Japan, for example, has been running a ratio of well over 200% for a decade with no signs of default. In fact, investors think the Japanese government and economy are solid enough that the Japanese government borrows money at the lowest interest rates in the world.

Another very serious problem with the ratio is that when the ratio goes up, people assume it is because of deficit spending and borrowing. In reality, most times when ratios go up it is because a recession or austerity program has shrunken the size of the economy and GDP. For example, since 2007 the U.S ratio has gone up a lot. But most of the increase has been because of the decline in GDP, not because of the stimulus spending program.

Finally, the last problem with measure is the very idea that it measures likelihood of default. The empirical data on the relationship is weak. Most importantly, default really happens when the debt-to-GDP ratio goes up AND the country borrows in somebody else’s currency (like small developing nations) AND the country has either fixed exchange rates or a gold standard. These conditions apply to those nations that are part of the Eurozone – the countries that use the Euro as their currency. These conditions also apply to many smaller developing nations. These conditions absolutely DO NOT APPLY to large developed nations with their own currencies such as the U.S., U.K., Canada, Japan, Australia, Switzerland, and many others.

So, overall, the ratio is actually a pretty poor measure. It’s useful in some esoteric technical econometric studies, but as a guide to whether the nation should cutting spending or not, it’s a horrible measure.

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5 thoughts on “Is Debt-to-GDP a Good Measure?”

Thanks a lot, for your explanations, Jim! Another question is raising up after I’ve read this article: Since the given “ratio is actually a pretty poor measure”, what kind of measures should I refer in order to evaluate how healthy the national economy is?

Debt-to-GDP is a very poor measure of the health of a nation or it’s economy. The best measures are:
1. Real GDP per capita – tells you general level of income per person
2. Real GDP Growth rates
3. Unemployment rate – lower is better, and close to 2-3% means really full employment

beyond that, the next indicator would be:
4. Inflation rate – low single digits is OK, higher than that typically means troubles ahead

If you really want to know how healthy the government budget is, check the interest rates on the government bonds. Low rates means investors have enormous confidence and consider those governments sound.

OK, thanks.
Following your statements: Firstly, does it mean that the US government budget is healthy since the bonds interest rates are low?
Secondly, another thing that is confusing me – all those indicators could look decent and suddenly some crisis breaks the whole logic of these numbers. The financial crisis in 2008 is a good example. At least I feel that way. Just a few were warning about coming troubles all the rest didn’t care. And I wonder what indicators those people took into consideration in order to see closing troubles? I doubt that they were using just general indicators. I think they were looking somewhere deeper. I would love to know this way of analysis.

The public debt (really, private sector debt) seems to be a cumulative quantity. This is divided by a GDP(per year) which varies from year to year. The ratio is in years. Adding government debts to the public debt seems to violate sector balances because government deficits are the source of money. The total debt is a muddled plot. Also adding inter-departmental accounts within the government makes it even more muddled. I do not understand what the plot means.
Partha

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This my economics blog for students and others. I teach econ (mostly principles) at Lansing Community College, where I spend my time trying to translate economic theory into plain language for students and make sense of economic events. This blog is part of that effort. Everybody is welcome, not just students. For more about me, see my teaching portfolio (jimluke.com) or my eproph.com blog.